It is not surprisingly, my post about “Capitalization and Amortization of Software Cost“ been gaining lots of reaction and questions on the ground [through email], particularly from software companies or accountants who take care of a software company. Despite that software industry is considered as a dynamic business, cost capitalization is one an old—constant debate in the accounting world. Back to the question; when should cost be capitalized? AOL is a good example to helps to showcase the judgment involved in, and potentially significant effects of, management decisions aimed at determining whether costs incurred should be capitalized or expensed.
In this post, I am going to answer the questions. With extensive life case studies come along with this post, I believe it gives a better understanding about cost capitalization concept and practices. It is not only about AOL, as I said, lots of real-life examples. Enjoy!
Back to the AOL case, the principle guiding these decisions, known generally as “the matching principle”, is simple enough. The principle ties “expense recognition” to “revenue recognition“; dictating that efforts, as represented by expenses, be matched with accomplishments (i.e., revenue), whenever it is reasonable and practicable to do so.
For example: inventory costs are not charged to cost of goods sold when the inventory is purchased. Rather, those costs are charged to expense when the inventory is sold. That way the cost of the inventory and the revenue generated by its sale are reported on the income statement in the same time period.
Similarly, a bonus paid a salesperson for completing a sale or the estimated cost of providing warranty repairs over an agreed-upon warranty period are expensed in the same time period that the related revenue is recognized. In this way, expenses incurred are matched with the recognized revenue.
Allocating Costs in a Rational and Systematic Manner
Most costs do not have such a clear association with revenue as can exist for inventory costs or a sales bonus or the estimated costs of a warranty repair. As a result, a “systematic and rational allocation” policy is used to approximate the matching principle. Thus, because a long-lived asset contributes toward the generation of revenue over several periods, the asset’s cost must be allocated over those periods.
This reporting technique seems straightforward and works reasonably well for most expenditures. It is from this systematic and rational allocation approach that we get our current method of accounting for depreciation expense. Companies record assets purchased at their cost and then allocate that cost over the future periods that benefit. Consider the following example taken from the annual report of American Greetings Corp.:
Property, plant and equipment are carried at cost. Depreciation and amortization of buildings, equipment and fixtures is computed principally by the straight-line method over the useful lives of the various assets [America Greetings Corp., annual report, February 2000, p. 24]. The company records property, plant, and equipment at cost and then employs the straight-line method as a systematic and rational method for allocating that cost over the asset’s lives.
As seen with AOL, however, this systematic and rational allocation approach to matching is not always so straightforward. The method is particularly subjective when a transaction lacks a “discrete purchase event” as with property, plant, and equipment, and instead involves the incurrence of recurring expenditures over time. Management then is faced with the decision of whether to:
- capitalize those recurring expenditures
- reporting them as assets and later amortizing; or
them when incurred.
AOL decided initially to capitalize its subscriber acquisition costs. However, highlighting the subjectivity of its decision, a disagreement arose with the SEC as to the extent to which those costs actually benefited future periods. It was the SEC’s position that such future benefits were not sufficiently clear as to warrant capitalization. AOL eventually relented and wrote off the capitalized costs.
Examples of other costs for which there has been a recurring disagreement about the appropriateness of capitalization, include “software development” and “start-up costs” which I overview on the next section.
Software Development Costs
- The costs of developing new software applications are to be capitalized once technological feasibility is reached.
- Prior to that point, software development costs are expensed as incurred.
Technological feasibility is defined as that point at which all of the necessary planning, designing, coding, and testing activities have been completed to the extent needed to establish that the software application can meet its design specifications.
It is at that point that the software company has a more viable product and a higher likelihood of being able to realize its investment in the software through future revenue [Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed (Norwalk, CT: Financial Accounting Standards Board, August 1985)].
The following policy note provided by American Software, Inc.. It explains well how accounting for software development costs works:
Costs incurred internally to create a computer software product or to develop an enhancement to an existing product are charged to expense when incurred as research and development expense until technological feasibility for the respective product is established. Thereafter, all software development costs are capitalized and reported at the lower of unamortized cost or net realizable value. Capitalization ceases when the product or enhancement is available for general release to customers [American Software, Inc., annual report, April 2000. Information obtained from Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure, Inc., December 2000)].
The definition of technological feasibility as requiring completion of the necessary planning, designing, coding, and testing to establish that the software application can meet its design specifications would seem to be rather late in the development of a new software product.
In actuality, provided a software firm has a detailed program design, or a detailed step-by-step plan for completing the software, and has available the necessary skills and hardware and software technology to avoid insurmountable development obstacles, SOFTWARE COST CAN BE CAPITALIZED ONCE THE DETAIL PROGRAM DESIGN IS COMPLETE AND HIGH-RISK DEVELOPMENT ISSUES HAVE BEEN SOLVED.
Clearly, management judgment plays a large role in determining when technological feasibility is reached and when capitalization should begin. In fact, one could reasonably argue that managements can raise or lower amounts capitalized by choice, raising or lowering earnings in the process. For example: if a firm seeks to capitalize a significant amount of software costs incurred, it should develop a detailed program design and work out design bugs early in the development process.
As a form of earnings management, some software firms may seek to minimize the amount of software development costs capitalized or even to expense all of such costs, capitalizing none. One way to achieve such an outcome in accordance with generally accepted accounting principles is to avoid the preparation of detailed program design.
Capitalization must then wait until the necessary planning, designing, coding, and testing have been completed to establish that the software application can meet its design specifications. Because the amount of software development costs incurred beyond that point is likely immaterial, it may be sufficiently late in the development process to permit the expensing of all software development costs incurred.
For example, Microsoft Corp. provides this policy note for its software development expenditures:
Research and development costs are expensed as incurred. Statement of Financial Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company” [Microsoft Corp., Form 10-K annual report to the Securities and Exchange Commission, June 2000, Exhibit 13.4, p. 6].
Attesting to the significant effect on earnings that a company’s software capitalization policy can have, consider again the case of American Software. If the company were to follow Microsoft’s approach and expense all of its software development costs, cumulative pretax results across the three-year period 1998 through 2000 would have been lower by $13,733,000 (sum of annual amounts capitalized minus amounts amortized). Had it followed this approach, the company’s reported cumulative pretax loss over the 1998 through 2000 time frame would have been much worse.
Many firms incur costs in developing software for their own internal use. Such costs are expensed currently until the preliminary development stage of the project is completed. After that point, essentially when a conceptual design for the software is completed, costs incurred on software are capitalized.
Consider this disclosure from the annual report of AbleAuctions.Com, Inc.:
Computer software costs incurred in the preliminary development stage are expensed as incurred. Computer software costs incurred during the application development stage are capitalized and amortized over the software’s estimated useful life [AbleAuctions.Com, Inc. annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000].
Accounting for start-up costs, which consist of costs related to such onetime activities as opening a new facility, introducing a new product or service, commencing activities in a new territory, pursuing a new class of customer, or initiating a new process in an existing or new facility, has changed markedly in recent years. Statement of Position 98-5, Reporting on the Costs of Start-Up Activities, now requires that all costs incurred related to start-up activities are to be expensed. Capitalization, no matter how strong an apparent link between current costs and future revenue might be, is no longer an option [Statement of Position No. 98-5, Reporting on the Costs of Start-Up Activities (New York: American Institute of CPAs, 1998)].
Prior to the effective date in 1999 of SOP 98-5, companies did just about anything when accounting for start-up activities.
Capitalized Interest Costs
In the United States, interest incurred on monies invested in an asset under construction is capitalized and added to the cost of the asset. Interest capitalization begins with the incurrence of construction costs and ceases when the asset is complete and ready for service. The amount of interest capitalized is actually “avoidable interest” and includes interest on monies borrowed specifically for the construction of the asset in question. In addition, interest on other borrowed funds that technically could have been repaid had available monies not been committed to the new construction project are also subject to capitalization.
Capitalized interest is netted against interest expense reported on the income statement and, depending on the nature of the ongoing construction activity, is added either to the cost of property, plant, and equipment items under construction or to discrete inventory projects, such as homes, ships, and bridges. Amounts capitalized are amortized and included in depreciation expense as property, plant, and equipment items are used in operations. Interest capitalized to inventory projects is included in cost of goods sold when the inventory item is sold. Two examples follow that are consistent with these policies.
In the first example, Ameristar Casinos, Inc., is capitalizing interest into the cost of property, plant, and equipment under construction:
Costs related to the validation of new manufacturing facilities and equipment are capitalized prior to the assets being placed in service. In addition, interest is capitalized related to the construction of such assets. Such costs and capitalized interest are amortized over the estimated useful lives of the related assets [Ameristar Casinos, Inc., annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000].
There are limits to the amount of interest that can be capitalized. For example: excluding limited exceptions for regulated utilities, the amount of interest capitalized cannot exceed the amount of interest incurred.
In addition, capitalization cannot continue if it were to result in the cost of an asset exceeding its net realizable value, or the amount for which an asset could be sold less the costs of sale. This net realizable value rule, or NRV rule, provides a natural limit on the amount of interest that can be capitalized and helps to prevent overcapitalization.
After periods during which significant amounts of interest costs have been capitalized, a sudden decline in construction activity can lead to sharp increases in net interest expense and a reduction in earnings.
For example: during a three-year period, interest capitalized by Domtar, Inc., declined from $20 million for the year ended December 1997 to $1 million in 1998 and $0 in 1999. At the same time, interest expense net of interest capitalized increased from $50 million in 1997 to $91 million in 1998 and $111 million in 1999 [Domtar, Inc. annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000].
Construction delays and cost overruns also can lead to earnings problems for companies that capitalize interest. As costs for assets under construction accumulate, cost moves ever closer to net realizable value. Once NRV is reached, future interest cannot be capitalized. Even additional construction costs will need to be expensed to prevent carrying the asset at an amount greater than NRV.
Moreover, as capitalized interest adds to the cost of assets, write-downs due to problems with assets becoming value-impaired will be greater.
For example: in 1999 U.S. Foodservice, Inc., a company with a long history of capitalizing interest on property, plant, and equipment items under construction, recorded a special charge to write down certain of these assets to net realizable value. Capitalized interest had increased the cost of these assets and added to the amount of the write-down. As noted by the company:
The Company [U.S. Foodservice, Inc.] recognized a non-cash asset impairment charge of $35.5 million related to the Company’s plan to consolidate and realign certain operating units and install new management information systems at each of the Company’s operating units. These charges consist of write-downs to net realizable value of assets of operating units that are being consolidated or realigned.
Other Capitalized Expenditures
A review of corporate annual reports turned up many other examples of expenditures that are being capitalized by various companies. A partial list of these capitalized expenditures is provided below.
- About.Com, Inc. (1999): URL costs and deferred offering costs in connection with initial public offering (IPO)
- Darling International, Inc. (1999): Environmental expenditures incurred to mitigate or prevent environmental contamination that has yet to occur and that may result from future operations
- Forcenergy, Inc. (1999): Productive and nonproductive petroleum exploration, acquisition, and development costs (full-cost method)
- Gehl Co. (1999): Costs incurred in conjunction with new indebtedness
- Hometown Auto Retailers, Inc (1999): Leasehold improvements
- InfoUSA, Inc. (1999): Direct marketing costs associated with the printing and mailing of brochures and catalogs
- J Jill Group, Inc. (1999): Creative and production costs associated with the company’s e-commerce website
- Lions Gate Entertainment Corp. (2000): Costs of producing film and television productions
- Miix Group, Inc. (1999): Policy acquisition costs representing commissions and other selling expenses
- RF Micro Devices, Inc. (2000): Costs of bringing the company’s first wafer fabrication facility to an operational state
- U.S. Aggregates, Inc.(1999): Expenditures for development, renewals, and betterments of quarries and gravel pits
Source: Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure, Inc., December 2000). Note: the year following each company name designates the specific annual report year end from which the data were compiled.
While GAAP may permit or even require capitalization of certain expenditures, it does not automatically indicate that the values assigned to any resulting assets are beyond question. The analyst has a responsibility to evaluate the realizability of such assets and make adjustments when they are warranted.
When no connection between costs and future-period revenue can be made, amounts incurred should be expensed currently. In such cases, the costs incurred do not benefit future periods and capitalization, which is tantamount to reporting current-period expenses as assets, is inappropriate. Included here would be general and administrative expenses and, in most cases, advertising and selling expenses.
Direct-Response Advertising – Direct-response advertising is an exception to the immediate expensing of selling expenses. The primary purpose of such advertising costs is to elicit sales to customers who can be shown to have responded specifically to the advertising in the past. Thus it can be demonstrated that such advertising will result in probable future economic benefits. Such costs can be capitalized when persuasive historical evidence permits formulation of a reliable estimate of the future revenue that can be obtained from incremental advertising expenditures [Statement of Position No. 93-7, Reporting on Advertising Costs (New York: American Institute of CPAs, 1993). Recall from an earlier example that the SEC determined that subscriber acquisition costs incurred by AOL did not fulfill the criteria for capitalization under guidelines for direct-response advertising.
Research and Development – Research and development costs, excluding expenditures on software development after technological feasibility is reached, also are expensed currently. One could reasonably argue that such expenditures will likely benefit future periods. Given the high-risk profile of such expenditures, however, and the uncertainty that future benefits will be derived from them, accounting standards require that such costs be expensed currently. Current expensing is a conservative approach that ensures consistency in practice across companies.
Accounting guidelines calling for the current expensing of R&D costs notwithstanding, some companies have attempted to capitalize these expenditures. For example: during the years 1988 through 1991, American Aircraft Corp. improperly capitalized R&D costs as tooling. The company, which was developing an advanced helicopter design, maintained that it had progressed past the R&D phase and that capitalization of costs incurred as production tooling was appropriate. In actuality, the costs incurred were not tooling and should have been expensed as incurred.
Patents and Licenses Closely related to the topic of accounting for R&D expenditures is the topic of accounting for the patents and licenses that can be derived from successful R&D. Capitalization is permitted of costs incurred to register or successfully defend a patent. Such expenditures are not considered to be R&D costs. Also, patents as well as licenses purchased from others can be reported as assets at the purchase price. Whether arising from the capitalization of internal costs incurred or through purchases from others, patents and licenses are amortized over the shorter of their legal or economic useful lives.
Amortizing Capitalized Costs
Consistent with the matching principle, costs capitalized in one period because they benefit future periods are amortized to expense in those future periods. This process of amortization, or spreading costs over several reporting periods, is used to allocate costs in a prescribed rational and systematic manner.
While here the term amortize is used generally to refer to the systematic allocation of all capitalized costs, the term frequently is used to refer to an allocation over time of the cost of intangible assets. For example, as noted by Harrah’s Entertainment, Inc.:
We amortize goodwill and other intangibles, including trademarks, on a straight-line basis over periods up to 40 years.
Depreciation, a form of amortization, is a term that typically is used to refer to an allocation of property, plant, and equipment accounts. As reported by A. Schulman, Inc.:
It is the Company’s policy to depreciate the cost of property, plant and equipment over the estimated useful lives.
Notwithstanding technical differences between the terms amortization and depreciation, they are used interchangeably here.
Depletion, also a form of amortization, refers to an allocation of the costs of natural resources—oil reserves, gravel pits, rock quarries, and the like. As disclosed by Engelhard Corp.:
Depletion of mineral deposits and mine development are provided under the units of production method.
Extended Amortization Periods
Generally accepted accounting principles provide no specific guidance as to the appropriate period of amortization for long-lived assets. As a result, judgment is needed, providing management with much discretion over reported results. By increasing an amortization period, periodic expense is lowered, raising pretax earnings.
Judgment and Amortization Periods
Evidence of the effects of professional judgment and the differences that can arise in amortization periods can be seen in the accounting policy notes that follow. All of the companies operate within a single general industry group, the manufacture of semiconductors.
From the annual report of Cypress Semiconductor Corp.:
Useful Lives in Years
Equipment 3 to 7
Buildings and leasehold improvements 7 to 10
Furniture and fixtures 5
From the annual report of Dallas Semiconductor Corp.:
Depreciation is calculated . . . over the estimated useful lives of the related assets, generally forty years for buildings, five to ten years on building improvements and two to nine years for computer hardware, software, and machinery and equipment.
From the annual report of Diodes, Inc.:
Property, plant and equipment are depreciated . . . the estimated useful lives, which range from 20 to 55 years for buildings and 1 to 10 years for machinery and equipment. Leasehold improvements are amortized using the straight-line method over 1 to 5 years.
As seen in these disclosures, all three companies depreciate property, plant, and equipment accounts over different time periods. Buildings alone are depreciated over periods as short as seven to 10 years for Cypress Semiconductor to as many as 55 years for Diodes.
As another example, Vitesse Semiconductor Corp. reports that it depreciates property
and equipment accounts over the relatively short period of three to five years, or approximately four years on average:
Vitesse began its fiscal 2000 with machinery and equipment at cost of $98,913,000. At year-end, the company reported machinery and equipment at cost of $171,761,000.56 Thus, during the year, the average cost of its machinery and equipment accounts was $135,337,000 (add the two amounts, $98,913,000 and $171,761,000, together and divide by 2). Using a four-year average depreciation period, the company would have depreciated the cost of its machinery and equipment by $33,834,000 ($135,337,000 divided by 4, assuming the straight-line method and no residual value). If the company were to extend the average useful lives of its equipment to six years, a period that is not out of line with other companies in the industry, depreciation would be reduced to $22,556,000 ($135,337,000 divided by 6), a reduction of $11,278,000, or 14% of pretax income of $81,678,000 for 2000.
Amortization periods certainly can have a significant effect on reported income. Similar differences exist for amortization periods assigned to intangibles. Consider the amortization periods primarily for intangibles provided below. The focus here is on intangibles other than goodwill. All of the companies are semiconductor manufacturers.
From the annual report of Analog Devices, Inc.:
Goodwill 5–10 years
Other Intangibles 5–10 years
From the annual report of Vitesse Semiconductor Corp.:
Goodwill and other intangibles are carried at cost less accumulated amortization, which is being provided on a straight-line basis over the economic useful lives of the respective assets, generally 5 to 15 years. As with property, plant, and equipment accounts, the amortization periods for intangibles can be diverse, ranging here from five to 15 years.
With much flexibility and discretion available to it, management may elect to employ an extended amortization period. Such a period is one that continues beyond a long-lived asset’s economic useful life. When put in place, an extended amortization period minimizes amortization expense and boosts reported earnings.